Thank You

Error.

Stocks may have welcomed the New Year with cheer, but bonds have kicked off 2013 with a week-long hangover.

The accord that averted the fiscal cliff quelled just enough market uncertainty to knock bonds out of their recent range-bound ways. Treasuries sold off, lifting yields, which move inversely to prices, to levels not seen since last May. Yields on longer-dated Treasuries rose more sharply than those on shorter-dated bonds, a phenomenon known in bond-speak as a "bear steepener" of the Treasury yield curve, indicative of investors' longer-term inflation fears.

To be sure, Treasury yields still fall well within broader boundaries that have grown familiar over the past 15 months and are still extraordinarily low by long-term standards. The Fed remains committed to pinning down short-term rates, although it divulged last week that its policy committee is more divided than previously known on how long to maintain key bond-buying programs. And Washington still faces a battle over raising the debt ceiling in two months. That could push skittish investors back into Treasuries despite threats of another U.S. credit-rating downgrade.

Somewhere down the road, inflation must kick in, and with it, growth. That bodes well for stocks. It doesn't bode well for bond funds that have sheltered investors over the past few years, especially when many types of bonds now trade above par value and are acutely exposed to small movements in interest rates.

The bond market dodged a bigger selloff Friday when the Labor Department reported tepid job growth that fell just short of economists' estimates, with the U.S. adding 155,000 jobs in December and the unemployment rate standing at 7.8%, matching November's upwardly revised figure. A separate private-sector jobs report a day earlier had painted a rosier picture, stoking concerns that a similarly robust Labor Department reading could have instigated a broad investor flight from bonds.

Many strategists see a shift out of bonds and into stocks commencing in 2013, but most still expect it to come later in the year, and gradually. While real interest rates are exceptionally low, Jim O'Neill, chairman of Goldman Sachs Asset Management, says the "equity risk premia" are elevated, indicating that stocks offer better value, at a time when several economic indicators have improved.

"All of these signals together suggest that it is increasingly dangerous to be heavily invested in government bonds," O'Neill wrote Friday. "And it raises the possibility that investors are starting to switch back from bonds into equities. As a large multi-product asset manager, we do not observe strong signs of this happening."

Despite the upbeat week and the market's general stolidity, munis remain susceptible to the same rate risks that threaten other high-grade bonds.

"We still see a negative skew to total returns for the market, though prospects are improving," write Morgan Stanley muni strategists Michael Zezas and Meghan Robson. "The biggest negative return driver remains the interest-rate environment, given that, at current rate levels, small yield increases can create negative returns."